Many organizations purchase management liability insurance to provide liability and defense cost protection for their directors and officers. But the management liability insurance protects the individuals only for their actions undertaken in an “insured capacity.” The policies are not intended to not protect them for actions they undertake in a capacity other than as a director or officer of the organization. These issues proved to be determinative in the action to decide whether or not D&O insurance issued to Jerry Sandusky’s organization, The Second Mile, covered the legal fees Sandusky incurred defending criminal and civil allegations involving misconduct with children.

 

In a March 1, 2013 Memorandum Opinion, Middle District of Pennsylvania Chief Judge Yvette Kane held that because the alleged misconduct did not arise in Sandusky’s capacity as an employee or executive of The Second Mile, the organization’s management liability insurer had no obligation to provide him defense cost coverage. A copy of Judge Kane’s opinion can be found here. As I note below, I have some concerns about this ruling.

 

Background

Sandusky founded The Second Mile in 1977. From 1977 until Sandusky was criminally indicted for offenses against children. Sandusky served at times as a volunteer and at times as an executive-level employee of the organization. In November 2011, a grand jury returned a report charging Sandusky with multiple crimes involving children. Following a trial, Sandusky was convicted of a total of 45 charges involving offenses against children. Sandusky has appealed his criminal conviction. Sandusky has also been named as a defendant in a separate civil proceeding brought by one of his alleged victims.

 

Sandusky sought coverage for the attorneys’ fees incurred in both the criminal and civil matters from The Second Mile’s management liability insurer. Sandusky sought coverage under both the D&O and EPL portions of the policy. The insurer advanced Sandusky’s defense expenses subject to a reservation of its rights under the policy and initiated an action seeking a judicial declaration that it had no obligation to fund Sandusky’s defense expenses. The insurer filed a motion for judgment on the pleadings, arguing that it would be against Pennsylvania public policy to indemnify Sandusky for the child molestation charges against him. As discussed here, in a June 2012 order, Judge Kane agreed that it would be against Pennsylvania public policy for the insurer to indemnify Sandusky, she reserved the question of whether it would be against public policy for the insurer to provide Sandusky with a defense.

 

After Sandusky’s criminal conviction, the insurer moved for summary judgment, arguing that the acts alleged against Sandusky were not undertaken in an insured capacity. The policy defined the term “Insured Capacity” to mean “the position or capacity of an Insured Person that causes him to meet the definition of Insured Person.” Sandusky argued that the meaning of this provision is ambiguous and the further discovery was required to determine the extent of the coverage provided under the policy. 

 

The March 1 Opinion

In her March 1, 2013 memorandum opinion, Judge Kane granted the carrier’s motion for summary judgment. She found the policy language regarding “Insured Capacity” to be “unambiguous.” She said that in order to determine “whether the actions that form the basis of the claims against Defendant were performed in his capacity or role as an executive or employee of The Second Mile,” she must review the allegations against him. She then reviewed the various abuse allegations that had been alleged against Sandusky. Among other things, she noted that the alleged abuse was alleged to have taken place in a variety of locations, all away from The Second Mile’s facilities.

 

Based on this review, she concluded that “it is clear that Defendant Sandusky was not acting in his capacity as an employee or executive of The Second Mile in sexually abusing and molesting the victims named in the criminal and civil cases brought against him, and the Court so finds.” She added that Sandusky was not alleged to have engaged in the alleged misconduct “in furtherance of his duties for The Second Mile.” She noted that the fact that Sandusky met his victims through The Second Mile or even that he sexually abused victims “during the course of activities at” The Second Mile “does not change the fact that his sexual abuse of children was personal in nature and performed in his individual capacity.” Because Sandusky’s alleged conduct “was clearly personal in nature and not in furtherance of his duties for The Second Mile, he is owed no criminal defense under the Policy.”

 

Discussion

The nature of these allegations is so repugnant and the fact that Sandusky has been convicted criminally makes it hard to spend any time thinking about the issues here. I certainly have no interest in defending Sandusky or trying to prove that he has not been dealt with fairly here.

 

Nevertheless I do have concerns about this ruling. It is easier to see my concerns if we forget about Sandusky and imagine instead that a volunteer or employee of a nonprofit organization has been unfairly targeted by abuse allegations, perhaps as a particularly vindictive part of a smear campaign. Let us say for purposes of this hypothetical that the allegations, though false, are otherwise as heinous as those against Sandusky.

 

My concern is that under Judge Kane’s ruling, even this falsely accused individual could not look to his origination’s management liability insurer for a defense. Her ruling does not depend on Sandusky’s conviction. She expressly says that “Sandusky’s offenses against children –whether proven or alleged – were not conduct in his capacity as an employee or executive of the Second Mile.” The allegations alone are enough to determine coverage, because “sexual abuse of children” is “personal in nature” and is “performed in individual capacity.” She even said that this conclusion would apply “even if he sexually abused victims “’during the course of activities of Second Mile.’” 

 

If the mere fact that allegations of sexual abuse are personal and individual is enough to preclude coverage for Sandusky, then are mere allegations sufficient to preclude coverage even for a nonprofit official who is falsely accused as part of a smear campaign? Keep in mind, Kane is not interpreting a clause of a policy in which the insurer says “we won’t insure even allegations of sexual molestation.” She was interpreting a clause that talks about the capacity in which a person was sued and for which he or she got sued. In our smear campaign hypothetical, the only reason my hypothetical smear campaign individual was targeted was because they were an official of the nonprofit. Are we prepared to say that this falsely accused individual is under no circumstances entitled to a defense, simply because of the nature of the allegations?

 

I would be much more comfortable all the way around with this decision if it were based on the fact that Sandusky was actually convicted. Of course, given that his criminal case is still on appeal the judgment in the criminal case is not final, and so the insurer might not be able to preclude coverage on the basis of the criminal conviction for some time yet.

 

When Judge Kane says that her conclusion that Sandusky was not acting in an insured capacity applies even though he allegedly abused victims “during the course of activities of Second Mile,” that’s when I get uncomfortable with this result. It would be very easy to shrug this result off because of the terrible things for which Sandusky was convicted. But because Judge Kane’s conclusion does not depend on the conviction, this same result could apply to any nonprofit official, even one who is falsely accused and would otherwise be forced to defend him or herself against outrageous allegations without insurance and at their own expense. I am very uncomfortable with this whole subject matter, but I am also not entirely comfortable with this decision.

 

I invite readers to weigh in on this topic, particularly those who take a different point of view on this decision than I do. (I know I am setting myself up for a raft of messages about the need for separate sexual molestation coverage or the possible problems with the bodily injury exclusion in the typical D&O insurance policy, and perhaps other similar arguments as well. Please bear in mind that my concerns here are focused exclusively on Judge Kane’s reasoning in denying coverage, not on whether there may be other questions that might affect coverage or whether there are alternative insurance arrangements that might better address the sexual molestation exposure.)

 

Whistleblower Watch: In my annual year-end round up of D&O insurance and liability issues, I more or less said that I thought 2013 would be the year of the whistleblower, or at least the year in which the whistleblower bounty provisions of the Dodd Frank Act kick into high gear. Well, here we are into the third month of 2013, and there still haven’t been any more whistleblower bounty awards. So was I wrong? Maybe I was, but before you decide, you need to take a look at the list that Mary Jane Wilmoth has been compiling over at the Whistleblower Protection Blog.

 

As Wilmoth reports, the SEC posts Notices of Covered Action when a final judgment order, by itself or with prior orders and judgments in the same action, results in monetary sanctions over $1 million. Individuals who voluntarily provided the SEC original information that led to successful enforcement in the actions identified in the Notices are eligible to apply for whistleblower awards. Once the Notices are posted, individuals have 90 days to apply for an award. The blog post lists 22 actions in which Notices have been posted. The list is complete through February 8, 2013. From looking at the dates on which the Notices have been posted, the SEC is putting up Notices regularly. The pretty clear inference is that this list is going to get a lot longer very rapidly.

 

Obviously not all of the Notices will lead to whistleblower bounty awards. Indeed, many will not, as there may not be a qualifying individual. But it seems highly probable that there will be some awards, perhaps many. In other words, it still seems possible that 2013 will be the year in which whistleblower bounty provisions kick into high gear. Stay tuned.

 

The modern public company D&O insurance policy provides coverage not only for the directors and officers of the company but also for the company itself – however, in the public company D&O insurance policy, the entity coverage applies only to securities claims, a limitation that sometimes leads to disputes whether or not a particular matter constitutes a securities claim.

 

A recent decision from the Central District of California took a look at whether the claims against a mortgage originator and securitizer involving the company’s issuance of mortgage-backed securities constituted a “Securities Claim” within the meaning of the company’s D&O insurance policy. In her February 26, 2013 order (here), Judge Josephine Tucker held that the claims were not “Securities Claims” within the meaning of the D&O policy and therefore that the insurer did not have a duty to advance defense costs.

 

Background

Until 2007, Impac Mortgage Holdings funded, sold and securitized residential mortgages. A unit of the company acquired mortgages that another company unit originated. The acquired mortgages were placed in a trust, which in turn issued certificates that were issued to an underwriter which then sold them to investors.

 

The coverage dispute relates to three separate claims that were asserted against Impac and its related entities. First, in April 2011, the Federal Home Loan Bank filed a state court complaint against Impac alleging unfair and deceptive acts as well as false and misleading statement in connection with the sale of the certificates. Second, in May 2011, Citigroup filed an action in the Central District of California against Impac, alleging violations of Sections 18 and 20 of the Securities Act of 1934, as well as negligent misrepresentation in connection with the Citigroup’ s purchase of certain other certificates. Finally, in April 2010, the Federal Reserve Bank of New York sent a letter to Impac referencing a dispute concerning priority of payments under four Impac securities offerings.

 

Impac submitted all three of these matters to its D&O insurer, seeking to have the insurer advance defense costs for all three matters and contending that all three arose out of Impac’s mortgage-backed securities business. The insurer denied coverage for all three claims and Impac filed an action against the D&O insurer, seeking a judicial declaration that the insurers ha a duty to advance defense costs. The parties cross-moved for summary judgment.

 

In pertinent part, the D&O insurance policy defined the term “Securities Claim” to mean a claim made against an insured:

 

(1) alleging a violation of any federal, state, local or foreign regulation, rule, or statute regulating securities …which is

(a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale of or offer or solicitation of an offer to purchase or sell any securities of an Organization;

 

The February 26 Ruling

In her February 26, 2012 order, Judge Tucker denied Impac’s motion for summary judgment and granted the D&O insurer’s summary judgment motion.

 

The D&O insurer had argued that the phrase “securities of the Organization” in the policy’s definition of the term “Securities Claim” referred to Impac’s own securities. Impac urged that the phrase had an additional meaning extending it to the mortgage-backed securities at issue in the underlying disputes. Impac argues that the term securities “of” the company encompasses securities that were possessed, connected or associated with the company.

 

With respect to Impac’s interpretation of the definition, Judge Tucker said:

 

The fact that it would be “semantically permissible” to interpret the Policies’ language as extending coverage to securities Impac bought, sold or was involved in the creation of is not sufficient to create coverage where none would otherwise exist. Rather the court must interpret the disputed language in context, w with regard to its intended function in the policy. Here, Impac has provided no admissible evidence that such an interpretation gives effect to the mutual intention of the parties. (Citations omitted)

 

Judge Tucker went on to note that Impac’s proposed interpretation “would require the phrase ‘securities of’ to carry multiple meaning within one policy definition.” She added that in the context of the full definition and policy, “the phrase ‘securities of’ makes sense only in reference to the securities of Impac itself.” She added that by ascribing multiple meaning so the phrase, “Impac’s construction would result in the provision of vastly broader coverage when the insured happens to engage in the business of securitizing mortgages and would cause a traditional D&O Policy for those particular companies to become a defacto E&O policy, i.e., a professional liability policy for entities.”

 

Judge Tucker also concluded that coverage was precluded by the D&O policy’s Error and Omissions Exclusion, precluding coverage for the company’s “performance of (or failure to perform) any professional services.” She noted in that regard that Impac had asserted against the co-defendant in the action – that is, Impac’s E&O insurer – that the underlying claims do arise out of the provision of professional services.

 

While she concluded that coverage was precluded under the D&O policy’s Errors and Omissions exclusion, Judge Tucker did rule in Impac’s favor ruling in a separate February 26, 2013 order (here) in Impac’s separate action against its E&O insurer. She held that that Impac’s securities transactions constituted professional services under the E&O policy. The parties had disputed whether the underlying claims, which related to Impac’s securitization of mortgages, arose out of Impac’s “performance of or failure to perform professional services for others.” The E&O policy defined Impac’s profession as “mortgage banker/mortgage broker.” Judge Tucker concluded that “the undisputed facts support the conclusion that the securitization was a central element in Impac’s mortgage banking/brokerage business.”

 

She also found that an exclusion cited by Lloyd’s was too ambiguous to warrant a denial of coverage. (The exclusion on which the E&O insurer had sought to rely excluded coverage for (1) “the depreciation (or the failure to appreciate) in value of any investment transaction” or (2) “any actual or alleged representation, advice, guarantee or warranty provided by or on behalf of an Insured with regard to the performance of any such investment.”)

 

Discussion

Like many coverage disputes, the dispute here over whether or not the claims at issue were or were not “Securities Claims” came down to an interpretation of the specific policy language at issue. But even without reference to the specific provisions in the policy, it would have represented an unexpected result for a company’s D&O insurance policy to pick up coverage for claims brought against it for its activities as a mortgage securitizer. As Judge Tucker correctly concluded, to do so would require the D&O insurance policy to provide coverage for the company’s delivery of professional services and would thereby convert the policy into an E&O insurance policy – when in fact the D&O policy carried an express exclusion of coverage for claims arising from the delivery of or the failure to deliver professional services.

 

In a Monday morning quarterbacking kind of a way, I find it irresistible to note that the extent of the policy’s coverage would have been clearer if the policy had not only generally excluded coverage for claims arising from the delivery of professional services but also expressly precluded from the definition of securities claim the company’s issuance of securities as part of its business as a mortgage securitizer.

 

While I don’t have a problem with Judge Tucker’s interpretation of the policy here, there are other gray areas that arise from time to time with respect to the extent of D&O insurance coverage for securities claims. There are claims that can arise when a company is hauled into a lawsuit alleging violations of the securities laws when the specific securities at issue may not be those of the insured company.

 

A couple of examples come to mind: say, for example, when the insured company has spun out one of its divisions as a stand alone, publicly traded entity, and the separate entities file claims not only against the new company but out of the predecessor firm as well. (For an example of this kind of claim, refer here). Another example is an aiding and abetting type lawsuit; say, for example, an insured company is alleged to have violated the securities laws by aiding another company misrepresent its financial condition (sure, private claimants can’t assert these kinds of claims under the federal securities laws, but the SEC can, and private claimants could assert their claims in reliance on state law liability theories). A D&O insurance policy limiting “Securities Claims” solely to claims relating to securities “of” the company arguably might preclude coverage for these claims. For that reason, I have preferred definitions of the term “Securities Claim” that extends coverage to any claim alleging a violation of the federal securities laws or state or local equivalents.

 

From the factual allegations in the Impac case, I can now see (from the carrier’s perspective), at least one flaw with a definition of the term “Securities Claim” that would extend coverage to any alleged violation of the securities laws. If Impac’s D&O policy had included this “any violation of the securities laws” formulation, the policy might well have picked up coverage for the claims against Impac arising from its mortgage securitization activities, which is a result I am certain that the D&O insurer did not intend here.

 

Recognition of this potential shortcoming to the “any violation of the securities laws” formulation suggests a need to devise a new formulation, one that would not hazard the kind of unintended result I noted in the preceding paragraph. My current thought is that perhaps the “any violation of the securities laws” formulation could include a provision expressly precluding coverage for the company’s issuance of securities other than its own securities.

 

This is the kind of topic that I think would benefit from a more thorough discussion. I welcome readers thoughts on this topic, under the heading – “toward a more perfect definition of the term ‘Securities Claim’.”

 

One final note for practitioners. In her analysis of the D&O policy, Judge Tucker correctly determines that traditional “duty to defend” case law and policy interpretation principles do not apply to a “duty to advance” D&O insurance policy. Those involved in litigating defense expense issues in the context of a D&O insurance policy may find her discussion of these issues useful.

 

A Stray Thought about Current Events: Pope Benedict has now moved on to his new life as Pope Emeritus. He undoubtedly hopes he can look forward to a life of quiet contemplation. Everyone here at The D&O Diary wishes him well. Whatever may lie ahead for him and for the Catholic Church, we can all be sure that Benedict will avoid the fate of one of his predecessors, Pope Formosus, who died in April 896 at the age of eighty-one after a five year papacy.

 

As described in Paul Collins’s recent book, The Birth of the West, a one-volume history of the nascent beginnings of modern Europe in the Tenth Century, following the death of Pope Formosus, his successor, Pope Stephen, convened what has become known as the “Cadaver Synod.” Ten months after Pope Formosus died, and under pressure from local magnates, Pope Stephen had his predecessor’s corpse exhumed, dressed in pontifical robes, and placed in a bishop’s chair to be tried for heresy. With troops surrounding the city, the terrified bishops called to pass judgment quickly found Formosus guilty of violating church law. All of his papal acts were declared void and his dead body, stripped of the papal robes, was reinterred as a layman in unconsecrated ground.

 

If Pope Stephen hoped this macabre ceremony would preserve peace, he was mistaken. Collins notes that “the Cadaver Synod marked the beginning of some of the worst internecine civil strife in the history of papal Rome.” All of this took place at a time when Europe was beset with recurring invasions from Vikings, Magyars and Saracens.

 

For those who are worried that the current Catholic Church faces challenges, well, things have been worse. Yet it was from this chaos that the rudiments of modern Europe slowly emerged. In any event, here’s hoping that the upcoming papal transition be smoother than some of those in the past have been.

 

Speaker’s Corner: On March 19, 2013, I will be speaking at a panel at the C5 Forum on D&O Liability Insurance in London. I will be participating on a panel entitled “The Impact of Increased Regulatory Oversight and Regulatory Investigations.” The panel will include my good friends Helga Munger of Munich Re, Cristiana Baez-Safa of XL and Ralf Rebetge of Chubb. The C5 Forum, which is excellent every year, includes a number of interesting sessions and an outstanding line up of speakers. Conference information, including registration instructions, can be found here. If you are planning on attending, I hope you will make a point of greeting me at the conference particularly if we have not previously met.

 

After market close on Friday, March 1, 2013, Warren Buffett delivered his annual letter to Berkshire shareholders. Buffett’s letters are widely read and closely studied for the insights he provides into the financial markets and into his own investment views. However, the most striking aspect of this year’s letter may be the topics he does not address. (Full Disclosure: I own BRK.B shares).

 

That is, despite Buffett’s age (82) and his recent health issues (in April 2012, he was diagnosed with stage 1 prostate cancer), Buffett does not address succession planning (except perhaps indirectly, as noted below). Despite the gridlock in Washington and the continuing difficulties in the Eurozone, Buffett does not directly discuss macroeconomic issues. Nor does this year’s letter include a marketplace critique, by contrast to recent years’ letters in which he has, for example, addressed the questionable value of investing in gold, potential problems with the dollar, or problems with the hedge fund business model.

 

What did Buffet talk about instead? Newspapers. Yes, newspapers.  Excluding Buffett’s description of the upcoming Berkshire shareholders’ meeting, the letter is eighteen pages long. Buffett devoted three pages – more than 16% of the entire letter — to newspapers. To be sure, Berkshire has purchased 28 daily newspapers in the last 15 months, but the total cost of these acquisitions is $344 million. Let’s put that into perspective. At year end, Berkshire had assets of $427.4 billion.

 

Why did Buffett devote so much of his letter to such a small part of Berkshire’s holdings? My theory is that it is a guilty conscience. He acknowledges at the outset that Berkshire’s newspaper acquisitions “may puzzle you” – not only because the newspaper business as a whole is in decline, but (more importantly) because the newspapers acquired “fell far short of meeting our off-stated size requirements for acquisitions.”  (Not only that, but Buffett famously stated four years ago that, despite Berkshire’s long-standing investments in the Washington Post and the Buffalo News, he would not buy a newspaper at any price.)

 

Buffett knows he has been straying from his own principles in acquiring the newspapers. He tries to justify all of this in a 23-paragraph defense, but the overly-long explanation fails to provide a single convincing reason why he would disregard his “oft-stated” principles to invest in an industry that he acknowledges is in decline.

 

In my view, Buffett acknowledges the real reason for the newspaper acquisitions at the outset, when he acknowledges that “Charlie and I love newspapers.” (Those readers who have read any of Buffett’s many biographies know that he was a paper boy for the Washington Post while his father served in Congress.) Buffett’s long defensive explanation for the newspaper purchasers reads to me like the product of a guilty conscience Buffett makes it clear that he intends to continue to purchase newspapers – but only, he emphasizes in italics “if the economics make sense.”

 

Another topic Buffett addresses is the question of dividends – as in, when will Berkshire start paying them? He acknowledges that shareholders frequently ask him about dividends, and he notes that it “puzzles them that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay nothing ourselves.” Anyone hoping that this prelude was the lead-in of an announcement that Berkshire is now about to pay dividends was sure to have their hopes dashed. In a lengthy, arithmetic-intensive exegesis, Buffett, in a schoolmaster role that he seems to relish, illustrates from a purely financial standpoint how Berkshire’s shareholders are better off (particularly from an after-tax point of view) if Berkshire retains and reinvests its earnings rather than paying them out in dividends. It is a masterful job.

 

The only thing that is missing from the lesson is an explanation of why he invests in so many dividend-paying companies himself. Surely if refraining from paying dividends really is better for Berkshire’s shareholders, why isn’t that true for shareholders of Coca-Cola, Wells Fargo and so on? Perhaps anticipating this concern, Buffett concludes his homily on dividends with a very brief and somewhat disconnected observation that companies should be clear and consistent about their dividend policy. He notes that he “applauds” the practices of many companies to pay consistent dividends while trying to increase them annually. 

 

Let me put it this way: if I were allowed to ask Buffett a question at the Berkshire shareholders’ meeting in May, I would refer to this portion of his letter and then tell him I don’t understand why retained earnings are in Berkshire’s shareholders’ interests, but annually growing dividend levels are in the interests of the shareholders of the companies in which Berkshire invests. (If possible, an explanation that doesn’t require the use of slide rule would be appreciated.)

 

I won’t get to ask that question, so I will content myself with noting that there is another very important reason that Buffett doesn’t want Berkshire to pay a dividend; given his ownership interest in the company, a Berkshire dividend would be a huge taxable event for him. I don’t think I am going out on a limb by saying that as long as Buffett is around, there will never be a Berkshire dividend.

 

Though this year’s letter does not, as I noted at the outset, directly address succession planning, Buffett does provide a little reassurance in that area to Berkshire shareholders. He notes in the letter’s introductory section that Todd Combs and Ted Wechsler, the two investment managers he recently hired, not only outperformed the S&P 500 in 2012 by “double-digit margins,” but he also notes (in tiny type-face) that their returns “left me in the dust as well.” He also notes that the value of Berkshire’s investments in one of the companies in which both Coombs and Wechsler have invested – Direct TV – now exceeds $1 billion and therefore qualifies as one of Berkshire’s 15 top common stock investments. Buffett also notes that as a result of these two manager’s investment returns “we have increased the funds managed by each to almost $5 billion” including amounts coming from the pension funds of some of the subsidiaries.

 

In case anyone misses the significance of these portions of the Berkshire letter, Buffett adds that “Todd and Ted are young and will be around to manage Berkshire’s massive portfolio long after Charlie and I have left the scene. You can rest easy when they take over. “ Lest anyone have any doubts about these two investment managers’ vigorous youth, Buffett notes (in talking about the 5K race to be run at the upcoming shareholders’ meeting) that Wechsler has run a marathon in 3:01 and Coombs has run a 5K in 22 minutes. (I find this emphasis on vigorous youth amusing in an annual report for a company whose annual meeting has for years has featured what amounts to a comedy routine by a couple of wise-cracking senior citizens)

 

And though Buffett says nothing about the current paralysis in Washington, he does have a message of hope for investors discouraged by the many problems besetting the world: “I made my first stock purchase in 1942 when the U.S. was suffering major losses throughout the Pacific war zone. Each day’s headlines told of more setbacks.” Throughout the period since, “every tomorrow has been uncertain. America’s destiny, however, has always been clear: ever-increasing abundance.” Berkshire is backing up these words with actions. In 2012, the company invested $9.8 billion in plant and equipment, with 88% of that investment in the United States – a figure that is 19% higher than in 2011, which was the previous high. “Opportunities,” Buffett writes, “continue to abound in America.”

 

Buffett focuses a portion of his letter talking about what he calls Berkshire’s “big four” investments – American Express, Coca-Cola, IBM and Wells Fargo. Buffett notes that Berkshire’s ownership interest in all four increased during 2012 and “is likely to increase in the future.” For long-time Buffett devotees such as myself, the inclusion of American Express, Coca-Cola and Wells Fargo on this this list is unremarkable, as all three are long-time Berkshire holdings. The show-stopper is IBM, the shares of which Buffett acquired for the first time in 2011. Not only is IBM now a “big four” investment, but the cost of Buffett’s IBM investments is larger than the cost of any other current common stock investment in Berkshire’s portfolio (the current value of the IBM investment is second only to Wells Fargo). After nearly a half a century of refusing to invest in technology companies because he said he didn’t understand them, Buffett’s most costly common stock investment is in a technology company. Clearly, Buffett’s little frolic into newspaper acquisitions is not the only instance where Buffett has strayed from his “oft stated” investment principles.

 

For readers of this blog, one area of particular interest will be Buffett’s analysis of Berkshire’s insurance businesses, which, according to Buffett, “shot the lights out last year.” The businesses have not only given Berkshire $73 million of “float” to invest, but also collectively produced a $1.6 billion pre-tax underwriting gain – the tenth consecutive year Berkshire’s insurance businesses collectively posted an underwriting profit. The underwriting profit, remarkable under any circumstances, is all them more noteworthy given the devastating impact of Hurricane Sandy. Among other things, for GEICO, Sandy represented the “largest single loss in history,” three times larger than the loss from Hurricane Katrina. From my reading of Berkshire’s financial statements, the insurance businesses produced a post-tax underwriting profit of $1.0 billion on earned premium of $34.5 billion, implying (on a rough calculation) a combined ratio of about 97.1.  

 

Buffett ruefully notes that the production of an underwriting profit is not uniform across the insurance industry; once again, as he has in several past shareholder letters, Buffett calls out State Farm, naming and shaming one of GEICO’s biggest competitors, because as of 2011, it had produced an underwriting loss in eight of the last eleven years. (The company’s 2012 results have not yet been released.) Buffett puts a concluding note on this condemnation with the observation that “There are a lot of ways to lose money in the insurance, and the industry never ceases searching for new ones.” (In fairness to State Farm and to readers of this blog, I should point out Buffett wrote almost the same identical things in his 2011 letter. Buffett does have a certain affinity for certain shop-worn themes.)

 

In his shareholder letter, Buffett emphasizes the sheer magnitude of the float that the insurance businesses have produced and how quickly it has grown. He doesn’t tease out how powerful the availability of this float is. It is only be reading through the footnotes of the accompanying financial statements that it can be learned that, in addition to the $1.6 billion in underwriting profit, the insurance businesses produced investment income of $3.4 billion.

 

Buffett concludes his analysis of the insurance business with a warning about the industry’s “dim prospects.” The industry has been benefitting from higher yields on its “legacy” bond portfolios. The yields on these older assets are much higher than are available today and that will be available “perhaps for many years.” As these legacy assets mature out of the portfolios, “earnings of insurers will be hurt in a significant way.”  

 

Much of the mainstream media coverage of Buffett’s letter has focused on the fact that by Buffett’s own reckoning, 2012 was a subpar year for Berkshire. Buffett himself notes the irony of using the term “subpar” to describe a year that produce a gain of $24.1 billion. But using the fact is that for only the ninth time in 48 years, the percentage gain in Berkshire’s book value was less than S&P’s percentage gain with dividends included. Because Buffett himself adopted this measure as Berkshire’s standard of comparison, it is fair to judge the company on that basis. But let’s be clear – Berkshire’s shareholders are not complaining.

 

In the twelve months, Berkshire’s share price has climbed a rather remarkable 27.28% (to an all-time high) compared to 11.16% for the S&P 500 The company had 2012 revenues $162 billion, which represents an increase of $13.2 billion over 2011’s $143 billion in revenue. As noted above, the company had 2012 year- end assets of $427.4 billion, compared to $392.6 billion at the end of 2011.

 

Berkshire’s shareholders may or may not be persuaded that they can “rest easy” when Buffett and Charlie Munger have left the scene. But for now, it seems likely that the company’s shareholders will be very happy once again to enjoy the octogenarians’ comedy routine at this year’s annual meeting. As for what may lie ahead, only time will tell.  All I know is that I happen to live with somebody who is exactly Buffett’s age, an experience that fills me with a great deal of trepidation about how long the current comedy routine will be amusing.

 

My review of the latest Buffett biography — "Tap Dancing to Work" — can be found here.

 

Plaintiff law firms continued to file lawsuits in connection with virtually every mergers and acquisitions transaction in 2012, according to an updated report from Cornerstone Research. The February 2013 report, which is entitled “Shareholder Litigation Involving Mergers and Acquistions” and which was authored by Robert M. Daines of Stanford Law School and Olga Koumrian of Cornerstone Research, shows that plaintiff law firms filed lawsuits on behalf of shareholders in 96 percent of M&A deals valued over $500 million and 93 percent of transactions valued over $100 million. Cornerstone Research’s February 28, 2013 press release regarding the report can be found here. The report itself can be found here.

 

According to the report, the litigation rate involving M&A deals in 2012 was essentially unchanged from 2011. In both 2011 and 2012, about 93% of all deals valued over $100 million attracted litigation, and 96% of all deals valued over $500 million attracted litigation. Deals valued over $100 million attracted an average of 4.8 lawsuits per deal in 2012 (down slightly from 5.3 per deal in 2011) and deals valued over $500 million attracted an average of 5.4 lawsuits in 2012 (down from 6.1 in 2011).

 

The report notes that after a contrary trend in recent years, in 2012 a larger percentage of cases were filed in Delaware. In 2012 39% of all M&A lawsuits were filed in Delaware compared to only 25% as recently as 2012. For Delaware Corporations, 16% of deals were challenged only in Delaware, compared with 9% in 2011 and only 2% in 2009.

 

Of the 58% of cases filed in 2012 that had been resolved, the majority (64%) settled. 33% of the resolved cases were dismissed and 3% were voluntarily withdrawn. (These case outcomes are roughly equal to prior years, although with a certain number of the 2012 cases yet unresolved the settlement rate is slightly higher than prior years.)

 

Of the 2012 cases that were settled, 81% of the settlements involved only additional disclosures (compared to 88% in 2011 and 76% in 2010). According to the report, “the parties in only one settlement acknowledged that litigation contributed to an increase in the merger price.” The deal termination fee was reduced in four cases and the parties reached agreement about appraisal rights in six cases. There were two large settlements in 2012, both relating to transactions announced in 2011: the $110 million settlement in the El Paso/Kinder Morgan case and the $49 million settlement in the Delphi Financial/Tokio Marine case.

 

The report includes a detailed table of the ten largest M&A lawsuit settlements during the period 2003-2012. As the report notes, most of the larger settlements in the table “included allegations of significant conflicts of interest.”

 

The average agreed-upon attorneys’ fee for the 2012 settlements was $725,000, The average fee in a disclosure only settlement was $540,000, down from $570,000 in 2011 and $710,000 in 2010. The report includes an analysis of the factors that influence the size of the fee request. The report notes that “plaintiff attorney fees appear to be influenced by the following factors: size of the settlement fund; other monetary benefit to shareholders; number of suits filed; time to settlement; and overall deal value.”

 

The report concludes with a review of the emerging litigation involving shareholder challenges relating to annual proxy votes and disclosures about executive compensation, which mounted quickly as 2012 progressed. The report notes that “as the 2013 proxy season approaches, this litigation may expand.”

 

Among the more controversial questions about the U.S.’s Foreign Corrupt Practices Act has been the extent of its reach in enforcement actions against foreign-domiciled individuals. Two recent decisions from the Southern District of New York reached differing conclusions about the statute’s reach. One case rejected the individual’s motion to dismiss the FCPA enforcement action, while the second granted the individual defendant’s motion to dismiss. Both decisions were based on the court’s personal jurisdiction over the individuals. The difference between the two decisions sheds some light on the question of extent of the FCPA’s reach over foreign individuals.

 

The first of these two rulings involved three executives of Magyar Telecom. The company was accused of involvement in schemes to bribe government officials in Macedonia and Montenegro. The company and its corporate parent, which were subject to U.S. jurisdiction because their securities (in the form of ADRs) traded on U.S. exchanges, entered into a non-prosecution agreement and also agreed to pay over $95 million in criminal fines and civil penalties.

 

The SEC also filed an enforcement proceeding against three Magyar executives. The SEC alleged that the three authorized payments to an intermediary, knowing the payments would be forwarded to government officials. The SEC also alleged that the individuals made false statements to the company’s auditors by signing representations that the company’s books and records were accurate. All three executives are Hungarian citizens and residents. The three moved to dismiss the SEC’s complaint, arguing that the U.S lacked personal jurisdiction over them.

 

In a February 8, 2013 order (here), Southern District of New York Judge Richard J. Sullivan denied the defendants’ motion to dismiss. Judge Sullivan held that the SEC had met its burden of showing that the exercise of personal jurisdiction over the three was consistent with constitutional due process. Judge Sullivan based his ruling not on the individuals’ physical location but their actions on Magyar’s behalf. The complaint, Sullivan observed, alleges that the defendants “engaged in a cover up through their statements to Magyar’s auditors knowing that [the company’s securities} traded on an American exchange and that prospective purchasers” would “likely be influences by any false financial filings.”

 

With respect to the question of whether or not the defendants had sufficient “minimum contacts” to support the constitutional exercise of jurisdiction, Judge Sullivan noted that “the Defendants here allegedly engaged in conduct that was designed to violate United States securities regulations and was thus necessarily directed toward the United States, even if not principally directed there.” He added that “because these companies made regular quarterly and annual consolidated filings during that time, Defendants knew or had reason to know that any false or misleading financial reports would be given to prospective American purchasers of those securities.”

 

Judge Sullivan specifically noted that his ruling did not envision any sort of rule that would subject any overseas employee of a company alleged to have violated the FCPA to personal jurisdiction in the U.S. He noted that “although Defendants’ alleged bribes may have taken place outside the Unites States…their concealment of those bribes, in conjunction with Magyar’s SEC filings, was allegedly directed toward the United States.”

 

The FCPA Blog’s post about the ruling can be found here. The FCPA Professor’s blog post about the Judge Sullivan’s ruling can be found here.

 

In the second of the two decisions, on February 19, 2013, Southern District of New York Judge Shira Scheindlin granted the motion to dismiss of one of the seven individual Siemens executives named in a FCPA enforcement action. Judge Scheindlin’s opinion can be found here. Siemens of course has been embroiled in one of the largest bribery investigations of all time. The SEC filed a separate enforcement action against several Siemens executives in connection with alleged bribery activities in Argentina. One of the defendants, Herbert Steffen, moved to dismiss contending that the court lacked personal jurisdiction over him. Steffen, a German citizen, had been CEO of Siemens Argentina twice before his retirement in 2003. He never worked in the U.S. The SEC alleged that Steffen helped facilitate a bribe to the Argentinian president to help secure a large government contract by allegedly encouraging another Siemens official to authorize bribes of Argentinian officials

 

In granting Steffen’s motion, Judge Scheindlin found that Steffen lacked sufficient contacts with the U.S. and dismissed the case against him. Judge Scheindlin found that “Steffen’s actions are far too attenuated from the resulting harm to establish minimum contacts.” She noted that “the SEC does not allege that he directed, ordered or even had awareness of the cover ups … much less that he had any involvement in the falsification of SEC filings in furtherance of the cover ups.”

 

Judge Scheindlin went on to observe that the exercise of jurisdiction over foreign defendants based on their effects upon SEC filings is “in need of a limiting principle,” adding that “if this Court were to hold that Steffen’s support for the bribery contact satisfied the minimum contacts analysis, even though he neither authorized the bribe, nor directed the cover up, much less played any role in the falsified filings, minimum contacts would be boundless.”

 

In further considering whether it would be reasonable for the Court to exercise jurisdiction over Steffen, Judge Scheindlin noted that “Steffen’s lack of geographic ties to the United States, his age, his poor proficiency in English and the forum’s diminished interest in adjudicating the matter all weigh against personal jurisdiction.” She added that the SEC and the Department of Justice “have already received comprehensive remedies against Siemens” and “Germany has resolved an action against Steffen individually.”

 

The FCPA Blog’s discussion of Judge Scheindlin’s ruling (as well as a detailed discussion of the larger background regarding the anti-bribery enforcement proceedings involving Siemens) can be found here. Victor Li’s February 20, 2013 Am Law Litigation Daily article about the ruling can be found here.

 

These two cases reached differing results, although the differing outcomes obviously depended on some very case-specific factual differences. Outcomes of personal jurisdiction motions often are very fact specific. For that reason it could be argued that there is little significance to the fact that in one case the Court found that it had personal jurisdiction over the individual defendants and in another it did not.

 

Though personal jurisdiction rulings are notoriously fact-specific, there nevertheless are certain conclusions that can be drawn from these two decisions, particularly in consideration of the question when a foreign domiciled individual charged with an FCPA violation can be subject to personal jurisdiction in the U.S. As James Dowden and Nick Berg of the Ropes & Gray law firm noted in their February 27, 2013 Law 360 article entitled “Rare Guidance On FCPA’s Reach Over Foreign Nationals” (here, registration required), the two cases “reaffirm U.S. regulators’ long-standing position that the FCPA has broad applicability to foreign nationals, while also setting the outer limits of the civil scope of the FCPA.”

 

In that regard, Judge Scheindlin herself not only referred to Judge Sullivan’s ruling in the Magyar executives’ case, but she identified the critical distinctions between the two cases. She noted first that “there is ample (and growing support in the case law for the exercise of jurisdiction over individuals who played a role in falsifying or manipulating financial statements relied upon by U.S. investors in order to cover up illegal actions directed entirely at a foreign jurisdiction.” She cited Judge Sullivan’s ruling the Magyar executives’ case as an example where the court “exercised jurisdiction over individuals who orchestrated a bribery scheme … and as part of the bribery scheme signed off on misleading management representations to the company’s auditors and signed false SEC statements.”  However, as noted above, Scheindlin found that the Siemens executive in the case before her was not alleged to have been involved in the cover ups or the falsification of the SEC filings.

 

At a minimum, the two rulings signify that though U.S. courts may properly exercise personal jurisdiction over foreign individuals in FCPA enforcement action when the facts support jurisdiction, there is a also a point when a foreign-domiciled individual’s involvement in the alleged corrupt activity is too attenuated to support personal jurisdiction. The specific considerations that matter include the extent of the individual’s connection to the actual bribery, the extent of the individual’s role in any cover-up of the bribery, and the extent of the individual’s involvement in or contribution to the falsification of the company’s financial statements.

 

A February 2013 memorandum from the Arnold & Porter law firm discussing the two cases and entitled “Two Recent Decisions Address Jurisdiction Over Foreign Defendants in FCPA Cases” can be found here.

 

In a much anticipated ruling in the Amgen securities class action litigation, the U.S. Supreme Court, in a 6-3 majority opinion written by Justice Ginsburg, held that a securities plaintiff is not required to prove that the allegedly misleading statements are material as a prerequisite to class certification. Justice Thomas, Scalia and Kennedy dissented. A copy of the court’s February 27, 2013 opinion can be found here.

 

As detailed here, the plaintiffs alleged that Amgen and certain of its directors and officers has issued misrepresentations and omissions regarding the safety, efficacy and marketing of two of its flagship drugs. The plaintiffs moved for class certification. The District Court granted the motion to certify a class, rejecting the defendants arguments that the before certifying the class, the plaintiff should be required first to prove that the alleged misrepresentations were material, or in the alternative that the defendants should be permitted to present information rebutting the contention that the class certification was material. The defendants pursued an interlocutory appeal to the Ninth Circuit, which affirmed the district court. The Supreme Court granted the defendants’ petition for a writ of certiorari.

 

The questions before the Supreme Court had to do with the “predominance” requirement under Rule 23(b)(3) of the Federal Rules of Civil Procedure. This Rule provides that as a prerequisite to certifying a class, the court must determine that “questions of law of fact common to class members predominate.” Because it would be difficult for securities claimants to show that a class of shareholders had all relied on misrepresentations, the Court has recognized the “fraud on the market” presumption, which holds that investors rely on an efficient market to include into a company’s share price the public information about the company.

 

The defendants argued that because “materiality” is a requirement for the applicability of the “fraud on the market” theory, plaintiffs should be required to prove that the allegedly misleading statements were material in order to use the “fraud on the market” presumption (and thereby allow a Court to determine that common issues of reliance predominate for class certification purposes).

 

In raising these arguments, the defendants relied on a split within the Circuits on these questions. The Second Circuit, for example, had held that plaintiffs must prove and defendants may rebut materiality before class certification. The Third Circuit had held that plaintiffs need not prove materiality before class certification, but that the defendant may present rebuttal evidence. The Ninth Circuit had held that the plaintiff need not prove materiality before class certification.

 

Justice Ginsberg, writing for the majority, held that “proof of materiality is not required to establish that a proposed class is sufficiently cohesive to warrant adjudication by representation.” The plaintiff is “not required to prove materiality of Amgen’s alleged misrepresentations and omissions at the class-certification stage.” While the plaintiff “certainly must prove materiality to prevail on the merits,” such proof “is not a perquisite to class certification.”

 

Because materiality is judged “according to an objective standard, the materiality of Amgen’s alleged misrepresentations and omissions is a common questions to al members of the class.” The plaintiffs’ failure to proved materiality “would not result in individual questions predominating. Instead, a failure of proof on the issue of materiality would end the case, given that materiality is an essential element of the class members’ securities fraud claim.”

 

Justice Ginsberg’s added that the dissent view that the plaintiffs must first establish materiality to gain certification “would have us put the cart before the horse.”

 

The majority opinion also specifically rejected Amgen’s public policy argument that because of the enormous economic pressure that the mere existence of a securities class action lawsuit creates, plaintiffs should be required to prove materiality at the class certification state. Justice Scalia endorsed this view in his dissenting opinion. The majority rejected this argument, noting that this argument could be made for any element of a securities class action claim, yet the Court has previously held that other common elements – such as loss causation and the falsity or misleading nature of the defendant’s alleged misrepresentations — “need not be adjudicated before a class is certified.”

 

Justice Ginsburg also noted that Congress had amended the federal securities laws in the PSLRA, based on a recognition that securities suits were subject to abuse, yet Congress had “rejected calls to undo the fraud on the market presumption” and “did not decree that securities-fraud plaintiffs” must “prove each element of their claim before obtaining class certification.” Justice Ginsberg added that “we have no warrant to encumber securities-fraud litigation by adopting an atextual requirement of precertification proof of materiality that Congress, despite extensive involvement in the securities field, has not sanctioned.”   

 

While commentators will be digesting the Court’s opinion in coming days, and while it appears that there might be much fruitful inquiry in analyzing the interplay between the majority, concurring and dissenting opinions, the bottom line is that plaintiffs seeking class certification in a securities suit will not be required to prove materiality. This outcome not only spares plaintiffs the burden of a pre-certification contest on one of the merits issues, but is relieves the plaintiffs of that burden in the judicial circuits that up until now had imposed that requirement. Securities class action defendants, on the other hand, will now be deprived of one of their tools in trying to block class certification – a blow that will be felt particularly in those circuits (like the Second Circuit) that had held that proof of materiality is a prerequisite to class certification in a securities suit.

 

If nothing else, this case proves that even with the Court’s current line-up, the Court’s grant of certiorari in a securities suit is not invariably bad news for securities plaintiffs. Though plaintiffs have taken a number of defeats before the Court in recent years, the outcome have not been uniform. The outcome here may not have been entirely unexpected – summaries of oral argument (refer for example here) suggested that some of the justices were skeptical of the defendants’ arguments. Nevertheless, it is noteworthy that a Court that is perceived as favoring the defendants in securities cases has entered a majority opinion favorable to plaintiffs.

 

One final note is that the Court did not (at least on first reading) appear to do anything to alter the existence of the fraud on the market theory. As always, a close reading of Supreme Court cases is  required and a closer reading of this case might reveal subtle signals. There had been some speculation that the Court might use this case as an occasion to reconsider or alter the fraud on the market theory. But at least based on the initial reading it does not appear that the Court did so.

 

Special thanks to a loyal reader for alerting me to the Supreme Court’s opinon

In the current global economy, many companies have operations and assets in far-flung corners of the world. These geographically dispersed arrangements have a number of implications for the concerned companies. According to a recent decision from the Delaware Court of Chancery, the arrangements may also have important implications of these companies’ outside directors, at least for those companies organized under Delaware law. These implications could include heightened responsibilities and even heightened liability exposures that may come as a surprise to some outside directors.

 

These issues arose at a February 6, 2013 Delaware Court of Chancery hearing before Chancellor Leo E. Strine, Jr. in a shareholders’ derivative lawsuit involving Puda Coal, a Delaware corporation with significant operations in China. As a clear from the hearing transcript (a copy of which can be found here, Hat Tip to the Delaware Corporate & Commercial Litigation Blog) the parties at the hearing conceded that one of the Chinese members of the board –and at the time of the hearing, the sole remaining board director – had, in the words of Chancellor Strine “stolen” significant assets from the company, and that the “theft” had gone undetected for an extended period of time. (Further background regarding these events can be found here.) After the misappropriation of corporate assets was discovered (apparently by an online analyst) and after the two outside company directors who were represented at the hearing were unable to get answers to their questions, the two individual directors had resigned.

 

The shareholders’ derivative suit had been filed before the two individuals had resigned. The two individuals moved to dismiss the suit, arguing that the plaintiffs had failed to make the requisite demand on the company’s board, and also arguing that the plaintiffs had failed to state a claim on which relief could be granted.

 

Chancellor Strine largely denied the defendants’ motions, granting the motion (with leave to amend) solely with respect to the plaintiffs’ unjust enrichment claims. Chancellor Strine was particularly contemptuous of the defendants’ demand failure arguments, given that upon uncovering the problems at the company, the individuals did not take up the suit against the wrongdoer, but rather quit, which had the effect of leaving the alleged wrongdoer as the sole remaining director.

 

In rejecting the defendants’ motion in this regard, Chancellor Strine called the defendants’ arguments “astonishing” particularly since the if the motion were to be granted “control of the entire lawsuit” belongs to the remaining director’s determination. Among other things, Chancellor Strine invoked Kafka to characterize the result that the individual defendants sought in their demand failure argument.

 

The far more significant portion of Chancellor Strine’s discussion of the defendants’ dismissal motion has to do with his rejection of the defendants’ arguments that the plaintiffs had failed to state a claim. In rejecting the defendants’ arguments, Chancellor Strine articulated a vision of responsibility for independent directors of companies with overseas operations or assets that I think might come as a shock to many outside directors; he said that

 

If you’re going to have a company domiciled for purposes of its relations with investors in Delaware and the assets and operations of the company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot.  You better have in place a system of controls   to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company

…

This is a very troubling case in terms that, the use of a Delaware entity in something along these lines. Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors. I’m not mixing up care in the sense of negligence with loyalty here, in the sense of our duty of loyalty. I’m talking about the loyalty issue of understanding that if assets are in Russia, if they’re in Nigeria, if they’re in the Middle East, if they’re in China, that you’re not going to be able to sit in your home in the U.S. and do a conference call four times a year and discharge your duty of loyalty. That won’t cut it.

…

If it’s a situation where, frankly, all the flow of information is in the language that I don’t understand, in a culture where there’s, frankly, not legal strictures or structures or ethical mores yet that may be advanced to the level where I’m comfortable? It would be very difficult if I didn’t know the language, the tools. You better be careful there. You have a duty to think.

 

Chancellor’s comments appear in a hearing transcript and not in written order, but as Francis Pileggi notes in a February 19, 2013 post on his Delaware Corporate and Commercial Litigation Blog about the ruling in the Puda Coal case (here), in Delaware courts, transcript rulings can be cited in the briefs.

 

As Tariq Mundiya of the Willkie Farr law firm noted in a February 23, 2013 post about the case on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here), Chancellor Strine’s ruling “highlights the risks and challenges that may exist for directors of Delaware corporations with significant foreign assets or operations.”

 

Chancellor Strine articulates a very broad vision of independent directors’ oversight responsibilities for Delaware companies’ foreign operations or assets. The expectation that independent directors physically visit and inspect the foreign operations and also speak the local language in the foreign locations may come as something of a shock to many outside directors. These days many companies have operations in multiple companies; larger companies have operations around the world. Chancellor Strine’s expectation that outside directors must be both regularly physically present and culturally literate in the each of the locations of the company’s overseas operations may represent a vision of board responsibility that likely would exceed the expectations of many company directors.

 

As if that were not enough, Chancellor Strine also had words about the independent directors’ decisions to resign. As he said, “there are some circumstances in which running away does not immunize you. In fact it involves a breach of fiduciary duty.” He added that “if these directors are going to eventually testify that tat the time that they quit they believed that the chief executive officer of the company had stolen assets out from under the company, and they did not cause the company to sue or do anything, but they simply quit, I’m not sure that that’s a decision that itself is not a breach of fiduciary duty. And that’s another reason for sustaining the complaint.”

 

To be sure, this case involved admittedly extreme circumstances. And arguably Strine’s comments could be limited to cases in which a company’s assets or operations are exclusively concentrated in a single foreign country. But the sweeping vision of independent directors’ oversight responsibilities for their companies’ overseas operations — premised as it is on the presumption that it is the job of the directors to try to prevent what happened here – arguably could require a complete overhaul of the way that the boards of global companies think about their directors’ responsibilities. At a minimum, the requirements for a regular physical presence and a cultural literacy in the locations where a Delaware company has operations or assets may far exceed the expectations of many independent board members. If Strine’s vision of board oversight responsibilities were to become established and come to represent the Delaware standard, it could require a substantial revision of the way that many Delaware boards and directors think about their board responsibilities.  

 

At a minium, I expect that Chancellor Strine’s comments will launch a discussion on the question of directors’ roles in overseeing a company’s far-flung operations. The hot topic for directors used to be financial literacy. Perhaps the question will soon become language fluency and cultural literacy.

 

The improving trend that the banking industry has shown for the last three years accelerated in 2012, according the FDIC’s Quarterly Banking Profile for the final quarter of 2012, which was released on February 26, 2013. Overall, the industry reported 2012 earnings of $141.3 billion, which represents a 19.3 percent improvement over 2011 and the second-highest annual earnings ever reported for the industry (behind only the $153.billion earned in 2006, before the credit crisis emerged.). The FDIC”s latest Quarterly Banking Profile can be found here.

 

The agency’s February 26, 2013 press release about the report (here) quotes FDIC Chairman Martin Gruenberg as saying that “the improving trend that began more than three years ago gained further ground in the fourth quarter,” and that “balances of troubled loans declined, earnings rose from a year ago, and more institutions of all sizes showed improvement.

 

Sixty percent of all institutions reported improvements in their quarterly net income from a year ago. Asset quality indicators continued to improve as insured banks and thrifts charged off $18.6 billion in uncollectable loans during the quarter, down $7.0 billion (27.4 percent) from a year earlier.

 

In another positive sign, the number of failed institutions is also declining. Eight institutions failed in the fourth quarter of 2012, which is the lowest quarterly total since 2008, when two institutions failed. (So far during the first quarter of 2013, three banks have failed.) For all of 2012, there were a total of 51 bank failures, down from 92 in 2011 and 157 in 2010. The 2012 total of 51 bank failures represents the lowest annual number of bank failures since 2008, when 25 banks failed.

 

One thing that is clear is that the U.S. banking industry has been through a massive winnowing effect over the last several years. The FDIC’s quarterly reports shows that as of the end of 2012, there were only 7,083 reporting financial institutions, by comparison to the 8.534 reporting institutions at the end of the 2007. The 1,451 decline in the number of reporting institutions during that period represents a decline of 17%. The number of reporting institutions has declined steadily during that intervening five year period. Indeed, the number of reporting institutions decline from 7,357 at the end of 2011 to the 2012 year end number of 7,083, a decline of 274 institutions (3.72%).

 

During the fourth quarter 2012, the number of reporting institutions declined by 98 banks (1.31%), from 7,181 at the end of the third quarter of 2012 to the year end number of 7,083. The FDIC’s report states that most of this decline (88 out of 98 institutions) was attributable to the merger of institutions into other banks. The remainder is due to failures and closures. The unstated inference seems to be that the industry is improving as the weaker banks are merged out of existence.

 

Not all of the news in the FDIC’s quarterly report is positive. Among other things, the report notes that for the sixth quarter in a row, no new reporting institutions were added. The year 2012 is the first in FDIC history in which no new reporting institutions were added, and the second year in a row with no new start-up charters (the three new reporting institutions added in 2011 were all charters created to absorb failed banks).

 

And though the overall banking industry continues to improve, the number of “problem institutions” remains stubbornly high. (A “problem institution” is an insured depositary institution that is ranked either a “4” or a “5” on the agency’s 1-to-5 scale of risk and supervisory concern. The agency does not release the names of the banks on its “problem” list.) Though the number of institutions on the FDIC’s problem list declined for the seventh consecutive quarter in the fourth quarter of 2012, from 694 to 651 representing a decline of 6.2% in the number of problem institutions), the number of problem institutions remains high relative to the number of reporting institutions, which, as noted above, is also declining.

 

The 651 problem institutions at the end of 2012 represent a significant drop in the number of problem institutions from the end of 2011, when there were 813 problem institutions, and from the end of 2010, when there were 884 problem institutions. The 162 drop in the number of problem institutions between the end of 2011 and 2012 – a decline of nearly 20% in the number of problem institutions – represents a substantial drop in one year.

 

But the number of problem institutions as a percentage of reporting institutions remains stubbornly high. This is in part due to the fact that as the number of problem institutions declines, the number of reporting institutions is also declining. The 651 problem institutions as of the end of 2012 still represent 9.19% of all reporting institutions. Though this is down from the equivalent percentage as of the end of 2011 (when it was 11.01%), the 2012 year end percentage of problem institutions means that as of year end, nearly one out of every ten reporting institutions is a problem institution. By way of contrast, as of the end of 2007, the FDIC ranked only 76 institutions as problem institutions. Though subsequent events suggest that the 2007 year end number was artificially low, the 2007 number does show what the percentage of problem looks like when the industry is not under stress.

 

Though the industry as a whole remains on the road to recovery, the problems from the credit crisis continue to haunt the industry and the number of problem institutions persists at an elevated level.

 

As the numbers of failed banks have decline, the number of failed bank lawsuits has continued to grow, as I detailed in a recent post (here).

 

By the time you read this blog post, you undoubtedly will have seen one of the stories in the mainstream media reporting on the February 25, 2013 decision of Southern District Court Jed Rakoff ordering former Goldman Sachs director Rajat Gupta to repay most of the legal fees the company incurred in connection with the government’s investigation and prosecution of Gupta. In case you didn’t see the stories, you can find them, for example, here and here.

 

There are a number of interesting things about Judge Rakoff’s order, many of which garnered little attention in the mainstream media reports.

 

By way of background, readers may want to recall that Gupta was convicted in June 2012 of leaking boardroom secrets to Raj Rajaratnam, who relied on the leaked non-public information in making highly profitable securities trades. Gupta was sentenced in October 2012. Gupta is appealing his conviction.

 

Judge Rakoff did not enter the order ordering Gupta to repay Goldman in a separate proceeding. Rather, Judge Rakoff entered the order in connection with the criminal proceeding against Gupta, and in particular as part of his (Rakoff’s) deferred determination of restitution in connection with Gupta’s sentencing. Goldman had specially appeared in Gupta’s criminal case to seek restitution of the $6.9 million in fees it paid to the Sullivan & Cromwell law firm in connection with the criminal case and related matters. (Goldman later withdrew a request for restitution of Gupta’s salary and for restitution of legal fees incurred in connection with a Section 16(b) short-swing profits proceeding against Gupta, which would explain why the amount Rakoff awarded was below the restitution amount Goldman had originally requested.)

 

Goldman sought restitution under the Mandatory Victims Restitutions Act, which mandates restitution in a criminal case where an identifiable victim has suffered a pecuniary loss. Under the Act, the restitution may include “necessary” expenses incurred during participation in the investigation or prosecution of the offense. Under Second Circuit authority, necessary other expenses may include attorneys’ fees, provided that the court finds by a preponderance of the evidence that the expenses were necessary and were incurred in connection with the investigation or prosecution of the offense, and that they were incurred by victims of the offense.

 

Goldman submitted 542 pages of its counsel’s billing records, relating to a range of related matters, not just Gupta’s criminal proceedings alone. Gupta had argued that the restitution, if any, should be limited to fees incurred in his prosecution. But Judge Rakoff interpreted the relief to which Goldman is entitled under the Act broadly. Judge Rakoff said that “this Court has no difficulty in concluding, by a preponderance of the evidence, that nearly all of the expenses Goldman Sachs here claims were the necessary, direct, and foreseeable result of the investigation and prosecution of Gupta’s offense.” 

 

Among other things, Rakoff included expenses incurred during Goldman Sachs’s internal investigation into Gupta’s conduct; the fees Goldman incurred to attend post-verdict proceedings in Gupta’s case; the fees the company incurred in the parallel SEC case against Gupta; and the fees the company incurred in connection with Rajaratnam’s criminal prosecution.

 

It is important to highlight the fact that in ordering Gupta to repay Goldman for the fees it incurred, Rakoff was interpreting and applying the Mandatory Victims Restitution Act. Rakoff’s order did not involve or relate to any interpretation or application of Gupta’s rights for advancement of indemnification of his attorney’s fees under Goldman’s by-laws or under applicable state law. I emphasize this fact because, following Gupta’s conviction, there has been discussion in the press of Goldman’s rights (if any) to seek recoupment from Gupta under applicable principles governing advancement or indemnification.

 

It remains an interesting question whether or not Goldman might have had the right (or would have had the right if Gupta’s conviction is affirmed) to seek to establish in a separate civil proceeding that it had a right of recoupment. But Goldman was not relying on its recoupment rights and Judge Rakoff did not order Gupta to pay Goldman in reliance upon principles of advancement or indemnification. Rather, he was applying the Mandatory Victims Restitution Act.

 

The fact that Rakoff was applying the Act is also important in connection with the question of what the ruling might mean in other cases. The ruling is only going to be relevant in other cases where a corporate official has been criminally convicted and where there is an identifiable victim that has suffered a pecuniary loss. Absent a conviction, there would be no grounds for restitution. A company seeking restitution of attorneys’ fees and other expenses would have to meet the Act’s other requirements as well. (It should be noted that Goldman is not the only company to have sought restitution of attorneys’ fees from a former official convicted of a criminal offense; as discussed here, Morgan Stanley is seeking in a separate proceeding to recover millions it paid to and on behalf of Joseph Skowron, a former hedge fund manager for the company who plead guilty to insider trading.)

 

Although it does not appear to have been relevant in Gupta’s case, it is interesting to consider what subrogation rights a D&O insurer might have under the Act in the event of a criminal conviction. To the extent that the attorneys’ fees had been paid by an insurer, the insurer might take the position that it is subrogated to any victims’ restitution rights to which the company is entitled under the Act. Whether the insurer would be as successful casting itself as the victim in that situation is an issue the carrier would have to address.

 

Today’s Classic Rock Note:  (Hat Tip to The Meta Picture.com)

 

I am sure many readers were disturbed as I was by the February 19, 2013 New York Times article reporting that a Chinese army unit apparently has been executing a concentrated cyber-hacking program targeting U.S. companies and critical U.S. infrastructure. (The report of consulting firm Mandiant that was the basis of the Times article can be found here.) This story is part of a rising tide of media reports about cybersecurity risks. Indeed, concerns about these kinds of activities led President Obama’s February 12, 2013 Executive Order entitled “Improving Critical Infrastructure Cybersecurity” (here).

 

Although the recent disclosures are quite troubling, it is not news that cybersecurity risks represent a significant concern for just about every company involved in the current economy. Prior posts on this site (for example, here) have detailed the liability exposures that these risks represent for all of these companies and for their directors and officers. But while these issues are not new, it really seems that as we have headed into 2013, the volume on these issues has been turned up.. It now seems clear that cybersecurity is going to be one of the hot button issues for the foreseeable future, both in the media and for the affected companies.

 

The heightened scrutiny of cybersecurity issues has a number of important implications for potentially affected companies, and not just from an operational standpoint. These developments also have important implications for public company’s public disclosure statements, and, as a consequence, for the company’s potential regulatory and litigation exposures.

 

Indeed, according to a February 21, 2013 memo from the King & Spalding law firm entitled “Cybersecurity: The New Big Wave in Securities Litigation?” (here), “it is likely that this issue will continue to gain momentum among both government regulators and opportunistic plaintiff lawyers seeking to catch the next wave of shareholder litigation.” In particular, the failure to promptly disclose a cyber breach “may put a company at risk of facing formal SEC investigations, shareholder class actions, or derivative lawsuits.”

 

As the memo notes, the SEC “has already taken a firm stand on cybersecurity disclosures, and clearly views this issue as ripe for enforcement actions.” In October 2011, the SEC’s Division of Corporate Finance issued “Disclosure Guidance” on cybersecurity related issues. Among other things, the Guidance clarified that the agency expects companies to disclose the risk of cyber incidents among their “risk factors” in their periodic filings and also expects companies to disclose material cybersecurity breaches in their Management Discussion and Analysis.

 

The law firm memo notes that so far, the SEC’s Guidance “seems to have had little impact on corporate disclosure,” and that in many instances companies experiencing cyber breaches are “choosing to keep those events confidential.” However, “given the increasing awareness of this hot issue,” it seems “likely” that the SEC “will increase pressure on companies to disclose such events.” The memo adds that “companies that have experienced significant cybersecurity breaches should prepare themselves for potential SEC investigations and lawsuits.”

 

In addition to the risk of SEC enforcement action, companies experiencing cyber breaches also face the possibility of a securities class action lawsuit. However, the memo notes, a company experiencing a cyber breach “will likely not be a target of a securities class action unless the disclosure of the breach can be linked to a statistically significant drop in the company’s share price.” In that respect, it is worth noting that several high profile companies announcing cyber breaches have not experienced a significant drop in their stock price following the announcement. (For example, recent announcements by Facebook, Apple and Microsoft that they have been the target of sophisticated cyber attacks did not affect the companies’ share prices.) Nevertheless, it seems likely that at least some companies experiencing cyber breaches or subject to cyber attacks will also suffer a drop in their share price, and “thus result in securities class action litigation.” 

 

Companies that do not experience a share price decline following a cybersecurity incident may not get hit with securities class action litigation, but they are still susceptible to derivative lawsuits alleging, for example, that company directors breached their fiduciary duties by failing to ensure adequate security measures. As the law firm memo notes, shareholder may claim that senior management and directors “were either aware of or should have been aware of the breach and the company’s susceptibility to hacking incidents.” Of course, any lawsuit of this type would face significant hurdles, including the requirement to make a formal demand on the board as well as the business judgment rule.

 

In any event, it is clear that cybersecurity issues are going to be an increasing source of scrutiny for companies and their senior officials. This heightened scrutiny not only means that companies will be under pressure to take steps to ensure that their networks and information are secure, but also means that the companies will face pressure both to “disclose the risks associated with potential cybersecurity breaches and provide timely updates when actual breaches occur.” Companies that fall short on these disclosure expectations “will face a substantial risk of regulatory scrutiny and shareholder litigation.”

 

As Rick Bortnick of the Cozen O’Connor firm discussed in a prior guest post on this site (here), cyber security disclosures have already been the source of securities class action litigation, in the high profile case involving Heartland Payment Systems. Although that case was dismissed, Bortnick points out how different the circumstances and disclosures involved in that case might look if viewed through the prism of the SEC”s 2011 Disclosure Guidance.

 

Among other implications from these developments is that cybersecurity disclosure seems likely to be the subject of greatly increased scrutiny, suggesting that this disclosure – particularly precautionary disclosure forewarning investors of the possible adverse effects the company could expect in the event of a serious cyber attack – should become a priority for reporting companies.

 

Finally, these developments and the possible regulatory and litigation implications underscore the fact that cybersecurity exposures represent an important issue to be addressed as part of every company’s corporate insurance program. Indeed, the SEC itself considered the question of insurance for cybersecurity exposures to represent such a critical issue that, in its Disclosure Guidance, it specifically identified the insurance issue as one of the topics companies should address in their disclosure of cybersecurity issues.

 

The insurance issues related to cybersecurity include not only the question of whether companies should acquire dedicated cyber and network security insurance, but also includes the question of the protection available to the companies’ senior officials under their management liability insurance policies. The rapidly evolving nature of these issues and the related liability exposures underscores the importance for all companies to have a knowledgeable and experienced insurance professional involved in the design and implementation of their corporate insurance program.

 

Readers interested in the President’s recent Executive Order and its potential implications will want to take a look at the February 2012 article written by Lockton’s Bill Boeck entitled “Cybersecurity Executive Order: What We Know and What We Don’t Know” (here).

 

Those who are interested in the implications of these developments for corporate directors will want to review the recent guest post on this site by D&O maven Dan Bailey entitled “Cyber Risks: New Focus for Directors” (here).

 

Classic Rock Notes::In its February 23, 2013 review of new autobiography of record industry executive Clive Davis, the Wall Street Journal describes a critical incident that led Davis to become one of the recording industry’s most successful rock music producers. In June 1967, Davis attended the Monterey Pop Music festival, where he heard Janis Joplin deliver a version of Big Mama Thornton’s “Ball and Chain.” Davis described the event as “not merely one of Janis’s greatest moments onstage, but one of the classic performances in rock history. It was simply overwhelming.” Joplin was, according to Davis, “hypnotic” and “mesmermizing.” Davis says he thought on seeing her performance, “This is a social and musical revolution.”

 

Davis wasn’t exaggerating. Even in the grainy Internet video, Joplin’s performance will give you goosebumps. Crank up the volume on your computer and enjoy (watch for the cutaway shot of Mama Cass Elliot regarding Joplin in slackjawed amazement).